Ninth Circuit Reverses Tax Court on Timing of DOI Income

In Milenbach, 318 F3d 924 (9th Cir. 2003), affg in part and revg and remdg in part 106 TC 184 (1996), the Ninth Circuit reversed a Tax Court decision on when discharge of debtedness (DOI) income occurred. Although the decision addressed a number of issues, this item focuses exclusively on the DOI income aspects of the case.

Sec. 61(a)(12) includes in gross income income from discharge of indebtedness, which is income that arises when a creditor releases a debtor from an obligation incurred at the outset of the debtor-creditor relationship. The Supreme Court articulated this principle in Centennial Savings Bank FSB, 499 US 573 (1991) and held that the imposition of early withdrawal penalties on certificates of deposits (CDs) was not the discharge of the banks obligation to repay. When customers deposited money with the bank and the bank issued CDs, debtor-creditor relationships were created between the bank and the depositors. Like most CDs, the terms and conditions included an interest rate, maturity date and early withdrawal penalty.

Focusing on the meaning of the word discharge, the Supreme Court found that discharge of indebtedness conveys the forgiveness of, or the release from, an obligation to repay. A depositor who cashes in a CD before the maturity date and pays the early withdrawal penalty does not forgive or release any bank obligation. By paying principal and interest, less the penalty, the bank pays exactly what it was obligated to pay under the CDs terms. Although the bank has income equal to the penalty amount, the income was not from the release of an obligation incurred by the bank at the outset of its debtor-creditor relationship with the depositor. The Supreme Court held that to determine whether the debtor has realized DOI income, it is necessary to look at both the end result of the transaction and the repayment terms agreed to by the parties at the outset of the debtor-creditor relationship. (Emphasis in original.)

In Milenbach, the taxpayers owned the Los Angeles Raiders football team. In 1987, the Raiders announced an intention to leave Los Angeles and play their home games in Irwindale, California. In connection with this move, the Raiders executed a memorandum of agreement (MOA) with the city of Irwindale for a $115 million loan to construct a football stadium. Irwindale advanced the Raiders $10 million. Under the MOA, if Irwindale failed to perform its obligations, the Raiders obligations would be extinguished, including the obligation to repay the advance. The Raiders would be allowed to keep the advanced funds as consideration for the execution of the MOA.

The MOA stated that Irwindale proposed to finance the stadium by issuing general obligation bonds. In 1988, the state legislature passed a statute that precluded the citys use of such bonds to build a stadium. Despite this legislation, the Raiders continued to negotiate with the city through 1990, in an attempt to construct a stadium in Irwindale. All alternative financing schemes were rejected, however. The Raiders never repaid the $10 million advance.

Applying the Centennial Savings principles to the $10 million advance seems to indicate that the Raiders did not have DOI income. Irwindale did not forgive an obligation that the Raiders incurred at the outset of the debtor-creditor relationship. Because repayment of the $10 million advance was not required under the MOAs terms, there was no release of a repayment obligation. The Raiders had income as a result of the advance, but that income does not appear to be DOI income.

Nevertheless, the classification of the $10 million as DOI income was not in dispute before the Ninth Circuit; the issue was the timing of the discharge. Generally, debt is discharged when it becomes clear that the debt will never have to be repaid, based on a practical assessment of the facts and circumstances. The courts require only that the time of discharge be fixed by an identifiable event. Loan repayment need not become absolutely impossible before a debt is discharged. A slim possibility that a debt may still be enforced does not prevent it from being treated as discharged. Whether a debt has been discharged depends on the transactions substance. The courts often look beyond form (such as the surrender of, or the failure to surrender, a note).

The Tax Court had held that the Irwindale debt was discharged in 1988, primarily because the 1988 legislation made financing the stadium with general obligation bonds impossible. Applying a clear error standard of review, the Ninth Circuit reversed. The Tax Court had concluded that, under state law, the MOAs terms required Irwindale to fund the loan with general obligation bonds or to forfeit the advance. The Ninth Circuit interpreted state law differently, finding that the MOA must be interpreted to avoid forfeiture. Although the parties assumed that Irwindale would fund the loan with the general obligation bonds, such funding was not required. Forfeiture would occur only if Irwindale was unable to provide the funds, from whatever source. The 1988 legislation was simply an obstacle that the Raiders and Irwindale attempted to overcome.

The Ninth Circuit remanded the matter to the Tax Court to decide when the Irwindale debt was discharged and directed the lower court to perform a practical assessment of the facts and circumstances relating to the likelihood of payment, to determine when, as a practical matter, it became clear that Irwindale would not be able to fund the entire loan and that the stadium would not be built.

From Mary Van Leuven, J.D., LL.M., Washington, DC